Wednesday, October 22, 2014

There's a big difference between being a value investor and merely being a cheapskate. The dictum goes, "Price is what you pay; value's what you get." To the skilled investor, value reflects the exploitable wedge between price and value. It's a relative concept, rather than an absolute level. This is often hard to remember because we use the same words - "cheap" and "expensive" - to describe two concepts. Something can be cheap relative to its inherent qualities, or cheap in an absolute sense, which is to say selling at a low dollar price. It's often helpful to clarify which people mean.The father of value investing, Ben Graham, was occasionally unclear on this point. His most famous disciple, Warren Buffett, notably adapted his investing style to incorporate quality as a component of value (influenced by Charlie Munger). In fact, Graham almost made a gigantic error by being a cheapskate rather than a value investor. Buffett recounts, "I offered to go to work at Graham-Newman for nothing after I took Ben Graham's class but he turned me down as overvalued. He took this value stuff very seriously!" Buffett might just be being kind here - if I recall correctly, I've read elsewhere that Graham turned Buffett down because young Jewish men were being barred from so many places on Wall Street that he felt inclined to save spots for them to work at Graham-Newman. But at any rate, the thought of Graham turning away the bright young Buffett seems like an act of folly. The distinction between value investing and being a cheapskate applies to regular life too. I posted about a month ago about this paper by Bronnenberg, Dube, Gentzkow and Shapiro that found that informed consumers of headache remedies (such as pharmacists) were less likely to pay extra for national brands, preferring store brands and generics. BDGS suggest therefore that "misinformation explains a sizeable share of the brand premium for health products." In other words, those who are better informed can see past marketing and therefore opt for a lower priced product with the same efficacy.About a week after writing that post, I found myself choosing between a brand name health product costing $90 and a generic brand at $60. "Screw you, brand name," I proudly thought. "I've read my BDGS." Big mistake. Three weeks later, I discovered the product wasn't working, and was forced to cough up for the more expensive alternative. Really, I made two mistakes. First, I incorrectly extrapolated the BDGS finding from the relatively narrow world of headache remedies to a completely separate product. Second, the BDGS finding referred to informed consumers. Alas, that's not me. I'm just a guy who heard a podcast and read a paper. I believed I'd found an exploitable wedge between price and value - and I was wrong.Thankfully the mistake was minor, and reversible (well, I hope so!). Investing forces us to be both arrogant and humble at the same time, believing that the multitude of investors we call the market is wrong, but being conscious that we might be wrong. The world is full of value traps - investments that look "cheap" but are not. Equally, there are opportunities that appear expensive, when in fact the odds of success and future cash flows are sufficiently favourable as so offset a purportedly high price. I credit Charlie Munger and certainly Phil Fisher for clarifying my thinking on this point. Similarly, value investors sometimes take pride in being thrifty or being out-and-out cheapskates in their daily lives. That, I believe, is a big mistake. Knowing the difference between price and value is a crucial component of value investing - and indeed life.

Saturday, October 11, 2014

In Nov 2002, Ben Bernanke, then a member of the Fed Board of Governors, gave a speech to honour Milton Friedman's 90th birthday. In the speech, Bernanke summarized the findings of Friedman and Schwartz's work on the Great Depression, concluding that "Monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, "a stable monetary background" - for example as reflected in low and stable inflation." He famously ended, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."Less than 2 weeks later, Bernanke gave another important speech at the National Economists Club, entitled "Deflation: Making Sure "It" Doesn't Happen Here". While the first speech covered historical episodes of monetary-induced volatility, the second focused on future policy prescriptions to combat deflation, countering in particular the notion that monetary policy was impotent at the zero lower bound (ZLB).(Aside no.1: It's interesting that these two speeches, arguably the best-known of Bernanke's speeches, were given within 2 weeks of each other. As a Fed Governor, Bernanke was in the sweet spot of being able to be relatively candid while having access to the highest corridors of power. Most of his later speeches are necessarily more cautious, and are understandably less objective since they, to some extent, have to defend decisions that he and his colleagues took.)(Aside no. 2: Wikipedia tells me that Bernanke is married to Anna Friedmann, confirmed by the NYT. I guess Friedman & Schwartz's work had an even bigger impact on Bernanke than he knows. Milton Schwartz was his next option.)If you've never read the speeches, or if it's been awhile since you last read them, I encourage you to spend 30 minutes (I'm a slow reader) and marvel at their lucidity and prescience. Reading them isn't merely an academic exercise. For investors, the first would have warned you of the potential impacts of the ill-fated decisions in 2008 to focus on inflation. The second laid out the Bernanke playbook, and could have helped you understand the possible rebound in economic performance and asset prices. It's easy to say that in retrospect, of course. But I find it interesting to go back to these speeches as we wrestle with another question: Will we see another 2008?The answer to this question depends a great deal on one's reading of the causes of the 2007-2009 conflagration, and deciding if similar conditions are in place. You don't have to look far to find those worrying about the fragility of the financial markets. Noted bear John Hussman wrote recently, "I view the stock market as likely to lose more than half of its value from its recent highs to its ultimate low in this market cycle." A host of savvy investors, most pertinently Seth Klarman, have expressed their concerns about market valuations and sentiment. There are also those like the excellent SoberLook.com who look at this chart of investor sentiment (from Yardeni Research) and conclude that there isn't enough bearishness in the market:

And of course, the Fed has voiced its concerns about valuations in tech stocks and the leveraged loan market recently.I haven't exactly been a bundle of optimism this year, worrying that the Fed is extremely unlikely to allow (or generate) a boom that would make up for some of the lost growth of the past 7 years. And I agree there are many reasons to be bearish - the Fed concluding its asset purchase programme, the seemingly intractable problems in the Eurozone, slow relative growth in the Chinese economy, and a plethora of geopolitical conflicts.But still, I have to say, I just don't think conditions are the same for another meltdown. My quick summary of 2007-2009 is as follows: a serious financial crisis occurred due to lax credit conditions, poorly understood financial instruments, and inaccurate beliefs about risk. This interacted in powerful and catastrophic ways with serious monetary policy errors to produce an economic and financial spiral.Specifically, there was an inappropriate focus on inflation at the expense of growth, compounded by paralysis when confronted with the ZLB.The situation today seems a little different:(1) Sentiment does not seem as optimistic. There may be fewer bears, but there are fewer bulls as well. I don't think it's realistic to say that we've gone back to the go-go days of the Dotcom bubble or 2007. Investor psychology was profoundly altered by the experience of the dark days of 2008 in particular. Yes, 7 years later, the memories have faded a bit, but I simply don't buy the argument that investors are ready to throw caution to the wind. Are there sectors that are overvalued? Almost certainly. But that's how markets work. (2) The policy landscape is completely different. The psychological barrier of breaking $100 oil has long been shattered, reducing the risk of inflation-phobia. Far more importantly, the playbook of tools for easing at the ZLB has been firmly established. In his speech on deflation, Bernanke pointed out that "an essential element [of taming the inflation dragon] was the heightened understanding by central bankers and, equally as important, by political leaders and the public at large of the very high costs of allowing the economy to stray too far from price stability."A similar story applies to easing at the ZLB. There was a story in the news today about the Bank of Israel (which has been extremely innovative in the past few years) being willing to consider unconventional tools should rate cuts fail to achieve the inflation target. Stories like this no longer even make us bat an eyelid. Yes, the ECB is struggling to implement QE, but that's for political reasons. I accept, and worry, that there are short-term risks that the Fed would be relatively slow to reverse its tightening course even if serious global shocks occurred. But another 2008 simply doesn't seem to be in the offing.One of my favourite quotes (from one of my favourite books) is Atticus Finch's refrain "It's not time to worry yet" in "To Kill A Mockingbird". I suppose that Finch-ism captures how I feel about the state of the equity markets in particular. Successful long-term investing requires discipline - discipline to ride out periods of volatility, and discipline to take advantage of ebbs and flows in investor psychology. That's the best way I know to harvest risk premia over the long run.Of course there are times to worry, particularly when no-one else seems to be doing so. But for the time being, I'm taking the Fed at its word that, thanks to Milton and Anna, they won't do "it" again.